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December 2003Reserve Bank of Australia Bulletin

1

Bond Market Development

in East Asia1

The development of bond markets in theAsian region has become a focus of policy-

makers over the past few years, with at least

three intergovernmental working groups

among countries in the region currently

examining the issue. The work is being

undertaken in an effort to strengthen the

financial sectors of east Asian countries and

to reduce vulnerabilities to future financial

crises. Weaknesses identified at the time of the

Asian financial crisis included an excessivereliance on bank-intermediated financing and

difficulties in borrowing longer term,

particularly in local currency.

This article begins with a recap on why bond

markets should be developed, examines

progress in the Asian region to date and

concludes with a discussion on some recent

multilateral initiatives.

Why Develop LocalCurrency Bond Markets?

There are a number of reasons for

developing bond markets. Firstly, there may

be a specific borrowing need which can be

met efficiently in the non-intermediated debt

market. In the case of governments, for

example, there may be a need to fund fiscal

deficits. These can be quite large and can onlybe met by tapping the wide range of investors

available in the traded debt market. From a

governance perspective, the non-

intermediated debt market also has the

advantage of being more transparent and it

reduces the risk that governments will rely on

central bank funding. There are also positive

flow-on effects for other borrowers in terms

of providing a pricing benchmark for other

fixed-income securities.From a private sector perspective, borrowers

need to finance investment projects that are

expected to yield returns over a long period.

If long-term finance is not available from

banks (as is quite often the case) and bond

markets do not exist, firms may have to finance

the acquisition of long-term assets by

incurring short-term debt, thereby creating a

maturity mismatch. If firms attempt to

compensate for the lack of a domestic bondmarket by borrowing in international bond

markets, they may expose themselves to

excessive foreign exchange risk. Alternatively,

investment policies may be biased in favour

of short-term projects.

There are additional advantages in fostering

the development of local currency bond

markets. Local currency debt markets

promote more efficient financial markets by

generating a range of market yields that reflect

1. The east Asian countries referred to in this article are China, Hong Kong, Indonesia, Korea, Malaysia, Philippines,

Singapore, Taiwan and Thailand.



Bond Market Development in East Asia December 2003

2

the opportunity cost of funds at each maturity

in the local currency, an essential element for

efficient investment and financing decisions.

In particular, the existence of tradable

instruments based on a local currency yield

curve allows market participants to hedge their

exposures: fixed-rate liabilities can beconverted into floating-rate liabilities, and/or

foreign exchange exposures can be

transformed into local currency exposures via

the use of foreign exchange forwards or cross-

currency interest rate swaps. Arbitrage

opportunities between foreign and local

currency debt markets can also be exploited

to lower the cost of borrowing.

At a more general level, a local currency

yield curve contributes to the stability of thefinancial system. In addition to potentially

lowering the risk-adjusted cost of borrowing,

the overall level of risk should be reduced by

spreading it across many participants, and to

entities best placed to bear the risk. In the

context of the Asian region, the need to

strengthen the financial system in this way is

particularly important for those countries

seeking to liberalise their capital accounts. If

capital inflows are forced into short-term

obligations (such as bank deposits) because

longer-term debt instruments are not

available, the capital-importing nation is more

vulnerable to a sudden outflow of capital.

Another reason for developing bond

markets is to avoid concentrating

intermediation directly on banks. With banks

being highly leveraged, such concentration

may make the economy more susceptible to

crises. The damage caused to the real economy

by such crises is generally much higher, andthe necessary restructuring more protracted,

in the absence of a well-functioning bond

market. Even in cases where a bank is

providing the finance, a well-developed bond

market allows the transfer of this risk through

securitisation or other credit derivatives. Banks

are able to repackage loans and sell them as

bonds (such as mortgage-backed or other

asset-backed securities). This reduces banks’

exposure to credit and liquidity risk and can

allow them to manage any maturity mismatch.

The yield curve for government debt also

provides valuable information about

expectations of likely macroeconomic

developments and about market reactions to

monetary policy moves.2

Local Currency DebtMarkets in east Asia

There is a great diversity in the degree of

development of local currency bond markets

across east Asian countries. In terms of

absolute size, resident local currency issueswith remaining terms to maturity of more than

a year range from about US$2 billion in

Indonesia, to about US$465 billion in China

(Table 1). At just under US$1 000 billion, the

combined size of the bond markets of the nine

economies in east Asia is equivalent to about

8 per cent of the US bond market, or about

18 per cent of the Japanese market. Relative

to the size of these economies, the east Asian

local currency bond markets range from less

than 2 per cent of GDP in Indonesia, to

74 per cent in Malaysia. In comparison, bond

markets (both government and private)

amount to about 124 per cent of GDP in the

US, 134 per cent in Japan and 32 per cent in

Australia. (While this is the most relevant

measure of residents accessing longer-term

non-intermediated debt markets, it

understates the relative importance of markets

such as Hong Kong and Singapore (and for

that matter Australia) where local currencyissuance by non-residents is sizable; in the case

of Hong Kong, local currency issues by non-

residents are more than double issues by

residents.)

Much of the impetus for growth in non-

intermediated debt markets in Asia has come

from the government sector and was

associated with the Asian financial crisis. The

crisis led to a large slowdown in economic

2. For a more detailed discussion of the reasons for developing local currency bond markets see BIS (2002),

‘The development of bond markets in emerging economies’, BIS Paper No 11, Bank for International Settlements.




3

activity in the region and a banking crisis

requiring a public sector injection of capital,

which resulted in a number of countries

moving from surplus fiscal positions to deficit

positions which have persisted. At the same

time, sharp adverse movements in exchange

rates and interest rates highlighted the

vulnerabilities of firms running large

unhedged foreign exchange and interest rate

positions, thereby emphasising the need to

promote the development of markets which

would enable firms to more effectively managetheir financial risks.

In response to these developments,




4

concentrated towards the shorter end of the

market – around 3 to 7 years – the major

exceptions being Singapore and Hong Kong

where liquidity is more evenly distributed.

Turnover in the debt markets is not

particularly high, though it has increased

steadily over the past five years in most

markets. Sovereign debt turnover ratios are

relatively low in Thailand and Malaysia (lessthan 5), and highest in Hong Kong (about

16); turnover in China was quite low in 2002,

though the World Bank suggests that it

increased quite markedly in the first half of

this year. In comparison, turnover ratios in

the US and Australia are about 30 and 9

respectively.Price discovery and secondary market

liquidity has also been enhanced by the

promotion of interest rate futures and

repurchase agreement (including securities

lending) markets. Korea, Singapore, Hong

Kong and Malaysia have interest rate futures

markets, with the Korean contracts being the

most active regionally; Taiwan is scheduled to

launch a futures contract towards the end of

this year. Liquidity in the secondary market

is also influenced by the participation of non-

residents in the market and taxation

arrangements. There are few restrictions on

participation in these markets by non-

residents, though procedural requirements

can be relatively onerous in some countries

and non-residents may still be subject to a

combination of withholding, capital gains and

turnover taxes (although there is scope in a

number of countries to have this burden

reduced). The one exception is China whereparticipation is limited to Qualified Foreign

Institutional Investors under changes

Table 2: Government Debt Issuance

Maturities* Issuance Turnover Futures Repurchase Non- With-

Years calendar ratio** market agree- resident holding

(2002) ments partici- tax

pation

China 2, 3, 5, 7, 10, 15, 20 ✕ 0.4 ✕ –

Hong Kong 2, 3, 5, 10 ✕ 15.6 ✓ ✓ ✓ ✕

Indonesia^ 5, 10 ✓ ✓

Korea 3, 5, 10 ✓ 9.6 ✓ ✓ ✓ ✓

Malaysia 3, 7, 10, 15, 20 ✓ 3.7 ✓ Limited ✓

Philippines 2, 5, 7, 10, 20 ✓ ✓

Singapore 2, 5, 7, 10, 15 ✓ 5.0 ✓ ✓ ✓ ✕

Taiwan 10, 15, 20 ✓ ✓

Thailand 2, 5, 7, 10, 14 ✓ 2.5 ✓ ✓ ✓

* Two years and longer

** Annual bond turnover as a share of securities outstanding

^ Includes recapitalisation bonds

Sources: National central banks

Graph 1

0

20

40

60

80

100

120

0

20

40

60

80

100

120

Asia Excluding Japan – GovernmentDebt by Maturity

US$b

Source: Bloomberg

US$b

2 6 10 14 18 22 26

Remaining maturity – years

■ Foreign currency ■ Local currency

30




5

introduced in November 2002. Most

countries follow a book-entry system of

clearing and have introduced a delivery-

versus-payment system.

Traditionally banks have been the largest

holders of public sector securities in Asia,

accounting for around 60 per cent of publicsector securities on issue. Holdings of

institutional investors, such as insurance

companies and pension funds, are much

smaller, at around 20 per cent. This contrasts

with markets in industrialised economies

where the share of public sector debt held by

institutional investors is higher. Accordingly,

institutional investors are seen as key to the

development of debt markets in emerging

markets in Asia given the high level of domestic savings in these countries. In

particular, the development of funded pension

schemes is expected to bring with it the need

to hold fixed-interest debt as a hedge against

long-dated liabilities. While some countries

have introduced rules governing portfolio

decisions of these investors (for mainly

prudential reasons), which have assisted in the

development of the public sector debt market,

most countries have been cautious, conscious

of introducing distortions typically associated

with captive market arrangements.

Corporate Sector DebtMarkets

Corporate sector debt markets (including

issues by government-sponsored enterprises)

have generally lagged the development of thegovernment debt market. For much of the

period up until the Asian financial crisis,

financial institutions accounted for most of

the activity in this market, usually in the form

of issues of fixed-income securities with

maturities of up to 10 years. This issuance was

disrupted around the time of the financial

crisis, but it has since recovered and it is now

well above pre-crisis levels (Graph 2).

The largest increase in issuance has been inSingapore, Korea and China. In the case of

Singapore, much of the growth has been in

structured products, with the share of private

sector debt issuance through special purpose

vehicles increasing from 37 per cent in 2001

to 50 per cent in 2002. The growth in these

vehicles has been driven by asset

securitisations (mainly of property) and credit

products. In Korea, three primarily state-

owned enterprises – the Korea Development

Bank, the Industrial Bank of Korea and the

Korea Deposit Insurance Corporation –

account for most of the issuance by financial

institutions. Similarly, in China government-

owned banks issue financial institution bonds.

These bonds, which are only issued to

residents, are used to fund longer-term

project-specific loans. In countries such as

Malaysia and Thailand, governments are

stepping up efforts to promote the

development of a secondary mortgage marketthrough issues by government-sponsored

financial enterprises.

There has been a gradual increase in

issuance by the non-financial corporate sector

over the latter part of the 1990s, though this

market remains relatively underdeveloped in

a number of countries (Graph 3). This owes

mainly to the fact that the government debt

market, which provides the foundation for a

number of hedging instruments, is still beingdeveloped and to the less homogeneous nature

of the corporate sector debt market, with

Graph 2

0

5

10

15

20

0

5

10

15

20

Financial Institution Debt Outstanding

%

Malaysia

%

Korea

2003**

Remaining maturity greater than 1 year,per cent of GDP

1991 1995 1999

TaiwanHong Kong

China*

Singapore*

* Includes debt with a remaining maturity of less than 1 year

** MarchSource: BIS

Thailand




6

issues varying widely from conventional

securities through to bonds with equity

warrants.

The main exceptions are Malaysia and

Korea where debt of non-financial institutions

as a ratio to GDP exceeds that of the US and

Japan. In Malaysia, issuers represent a broad

cross section of the economy, including utilitycompanies, manufacturers and retailers. The

tenure of new issues is typically 5 years. The

early establishment of a credit ratings agency

(in 1990) and the funding of government-

initiated infrastructure projects have been

important for the development of this market.

A wide range of corporate entities also issue

into the Korean market, with most corporate

bonds issued for three years, though there are

also 1- and 5-year bonds. A major change in

this market since the Asian financial crisis has

been the shift away from bank-guaranteed

bonds to non-guaranteed bonds with credit

ratings obtained from at least two credit rating

agencies. The Korean market experienced a

sharp pull-back in 1999 associated with the

collapse of the Daewoo group which dented

confidence in that market.

Relative to GDP, the Taiwanese non-

financial corporate sector debt market is

somewhat smaller with issues ranging from 2to 12 years (though more typically toward the

longer end of this spectrum). Issuance of

corporate bonds has picked up significantly

over the past three years after growth slowed

in 1999 when the government began to

require unsecured corporate bonds to be

credit-rated before they could be issued.

In addition to promoting the development

of a benchmark yield curve, a number of countries have taken steps over the past few

years to remove impediments to the

development of local currency corporate bond

markets. These include improving settlement

practices (Singapore, Malaysia), actively

promoting the development of asset-backed

securities markets (Hong Kong), encouraging

the establishment of credit ratings agencies

(Thailand and Malaysia), reviewing

regulations affecting the development of themarket (Taiwan and China) and improving

market transparency (Malaysia). At an

aggregate level, banks and institutional

investors account for most of the holdings of

corporate sector debt, with the split being

fairly even between the two, though it does

vary across markets.

It is difficult to establish to what extent

residents in these countries remain reliant on

non-intermediated borrowings denominatedin foreign currency, rather than local currency

borrowings. The largest deals so far this year

for the Asian corporate sector have generally

been denominated in US dollars. To some

extent this reflects a combination of the US

dollar market being considerably deeper and

more liquid – particularly for longer maturities

– than the domestic markets and the close link

between a number of the Asian currencies and

the US dollar. It is also possible that in well-

developed markets, such as those in HongKong and Singapore, residents are issuing

foreign currency bonds but then swapping the

proceeds back into local currency using

derivative contracts. (In this case, issuance by

non-residents in local currency tends to be

larger than normal.)

The Dealogic Bondware database of

primary issuance, which picks up widely

distributed issues, suggests that a number of

corporate borrowers continue to tap theforeign currency bond market, particularly for

longer maturities (Graph 4). Resident issues

Graph 3

0

10

20

30

40

0

10

20

30

40

Non-financial Institution Debt Outstanding

%

Malaysia

%

Korea

Remaining maturity greater than 1 year,per cent of GDP

Taiwan

Hong Kong

China*Singapore*

Thailand

* Includes debt with a remaining maturity of less than 1 year

** MarchSource: BIS

2003**1991 1995 1999




7

denominated in foreign currency account for

around one-third of total resident issuance

picked up by this data source, with this share

changing little over the past three years.

Foreign currency corporate issuance in the

region is concentrated in Hong Kong and

Korea: in Hong Kong foreign currency debt

is around 50 per cent of total corporate

issuance, whereas in Korea it amounts to only

25 per cent of the total (Graph 5). Foreign

currency issuance in other countries generally

accounts for around half of total corporate

debt issuance. At either end of the spectrum

sit China, which makes relatively little use of

foreign currency corporate debt, and the

Philippines, which issues mainly foreign

currency denominated corporate debt.

Recent MultilateralInitiatives

Development of regional bond markets has

become a policy priority for a number of

governments in the region. As noted earlier,

this is based on a consensus that bond market

development is an essential building block forimproving the efficiency of financial

intermediation in the region and reducing

potential currency and maturity mismatches.

Groups currently examining Asian bond

market development include Asia-Pacific

Economic Cooperation (APEC), the

Association of South East Asian Nations plus

Korea, Japan and China (ASEAN+3), and the

Asian Co-operation Dialogue (ACD). The

main focus of APEC and ASEAN+3 has been

on providing the infrastructure for the

development of viable local currency bond

markets. The APEC grouping’s work spans

the harmonisation of regulatory

infrastructure, the development of

securitisation and credit guarantee markets

and the development of new regional debt

products. ASEAN+3 working groups are

currently examining the role of credit ratings

agencies, settlement procedures and the

promotion of issuance by non-residents,particularly international organisations, in

Asian currencies. The possibility of issuing

bonds denominated in a basket of Asian

currencies is also being promoted by this

group. The aim of the more recently formed

ACD is to improve public awareness of the

various Asian bond market reform initiatives,

as well as to secure political support for them.

At a more practical level the Executives

Meeting of East Asian and Pacific (EMEAP)grouping of 11 central banks from the region

(Australia, China, Hong Kong SAR,

Graph 4

1 3 5 7 9 11 13 15 17 190

20

40

60

80

0

20

40

60

80

Asia Excluding Japan – CorporateDebt* by Maturity

US$b■ Foreign currency■ Local currency

US$b

>20

Remaining maturity – years* Includes financial institutions and public corporations

Source: Bondware

C h i n a

H o n g K o n g

I n d

o n e s i a

K o r e a

M a l a y s i a

P h i l i

p p i n e s

S i n g a p o r e

T a i w a n

T h

a i l a n d

0

25

50

75

100

125

150

175

0

25

50

75

100

125

150

175

Asia Excluding Japan – CorporateDebt* by Country

US$b

* Includes financial institutions and public corporationsSource: Bondware

US$b■ Foreign currency ■ Local currency

Graph 5




8

Indonesia, Japan, Korea, Malaysia, New

Zealand, the Philippines, Singapore and

Thailand) has established the Asian Bond

Fund (ABF), in conjunction with the Bank

for International Settlements. Established in

July 2003, it is designed to promote

development of regional bond markets andchannel some of the region’s foreign currency

reserves back into the region. Accordingly,

EMEAP member central banks have invested

a total of US$1 billion of foreign exchange

reserves in the fund, which invests in a basket

of US-dollar denominated bonds issued by

government and quasi-government issuers in

EMEAP economies (other than Australia,

New Zealand and Japan where bond markets

are already well developed). EMEAP has also

announced that it will study the feasibility of

extending the investment to include bonds

denominated in regional currencies. The

establishment of the US-dollar denominated

ABF is only a small step when judged againsteither the size of foreign exchange reserves in

the region or against bond market issuance in

the region. Nonetheless, it represents a firm

commitment by member central banks to

regional bond market development. Larger

gains are expected to accrue from the next

step – a local currency fund. R

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